Know Your KYC: Illuminating The Hedge Fund Perspective

1. An Unsustainable Path

As a prerequisite for doing business in the financial markets, Know Your Customer (KYC) has become a complex process that is increasingly expensive, resource-intensive and liable to complicate client/broker relationships. For many sell-side institutions that manage one-to-one interactions with multiple clients, KYC represents an unsustainable situation. Given that most of the cost burden of KYC is borne by the sell side, the majority of new solutions on the market tend to focus on sell-side needs. But KYC is fundamentally a two-way exchange of information and agreements, and new solutions need to take the requirements of both sides into account.

For hedge fund firms, KYC poses unique challenges. Hedge funds are increasing the number of their broker relationships due to market opportunities and trading strategies. This, in turn, increases the number of KYC processes that a hedge fund firm has to maintain. The firms are responsible for providing the data and documents brokers request, with limited visibility into how sensitive information will be used and distributed or which KYC policies apply to them. As a result, fund managers may become frustrated when one broker asks for a certain type of information but another broker handling a similar type of business asks deeper questions or requests a different set of documents. This type of confusion ultimately increases the time to onboard and puts strain on the client relationship.

2. The Hedge Fund Perspective

Hedge fund managers operate in a culture that requires privacy and discretion. In order to protect their investors and strategies, they share as little information as possible with any given counterparty. But the data and documents that are required for KYC run counter to this behavior.

Banks often need to request the financial details of investment management firms and identification of fund owners and other associated individuals. It should be noted that if banks could acquire KYC information from other sources, including public databases like EDGAR, they would, since no bank wants to start a new client relationship by making unwanted requests. But because hedge funds are predominantly private companies, banks currently have no choice but to ask hedge funds for the majority of these details directly.

Time To Trade Vs. A Common Policy

In addition, hedge funds often begin a trading relationship with a specific trade idea in mind. Many of these ideas are relatively time sensitive, so hedge funds want to execute them as quickly as possible in order to achieve optimal market pricing. But KYC must be completed before any trading can occur, which puts hedge funds in the difficult position of either rushing the process or abandoning the original idea.

This whole dynamic is further complicated because KYC policy varies so much from bank to bank and even within a bank. If a previous counterparty did not ask for the same details or agreements as the current counterparty in order to trade, why does the new counterparty require them? This happens frequently because KYC is governed by different laws, policies and regulatory bodies in various countries and even by product, and sell-side institutions may interpret these regulations differently.

Even more frustrating, the fund may be asked to provide information it knows the bank already has. This often occurs when a fund needs to establish a relationship with a different department or desk within the bank. It not only tests the fund manager’s patience but also raises questions about how many copies of the firm’s sensitive documents are stored in the bank’s servers.

A potential solution would be a common policy for document requirements that collects the superset of information needed from a hedge fund by each desk within the bank. It sounds simple, right? But this goes counter to the desire for a hedge fund to only provide certain data at certain times to certain counterparties. It may speed time to trade but results in fewer hedge funds wanting to deal with a broker.

KYC Data Security

Hedge funds also have concerns about the security of the information that they are asked to supply. This information pertains to both the hedge fund and its partners—personally identifiable information (PII) and information on trading strategies. Recent news about cybercrimes at banks and losses of customer data adds further worries about data security.

For their own and their investors’ protection, hedge funds need to understand who will see the information they deliver, how it will be handled within the bank, where it will be stored and how this storage system is safeguarded. In short, they need to have confidence in the chain of custody of this information. Conventional KYC practices cannot provide this level of assurance.